<HTML><HEAD> <META name=GENERATOR content="MSHTML 8.00.6001.19019"></HEAD> <BODY> <H1 class="cN-headingPage prepend-5 span-11 last">Inflation and debt could derail China </H1> <DIV class="push-0 span-11 last"><!-- cT-storyDetails --> <DIV class="cT-storyDetails cfix"> <H5>William Pesek </H5><CITE>June 7, 2011</CITE> <UL></UL></DIV> <DIV id=googleAds class="ad adSpot-textBox"></DIV><BOD> <DIV class=articleBody><!-- cT-imageLandscape --> <DIV class=cT-imageLandscape><IMG alt="Growing evidence that China's roaring economy is starting to slow has fed an investor debate." src="ctsChina%27s%20building%20boom%20slows-420x0.jpg"> <P>Growing evidence that China's roaring economy is starting to slow has fed an investor debate. <EM>Photo: Reuters</EM></P></DIV> <P>Credit downgrades can elicit fascinating reactions. Take a January move by Standard &amp; Poor's to cut Japan's rating to the same level as China's. I expected the backlash to come from Tokyo. Instead, it was the Chinese who were aghast.</P> <P>Every Chinese official I've met since is bewildered that 10 per cent growth and $US3 trillion ($2.8 trillion) of currency reserves don't buy a better grade than the AA- that China shares with an overly indebted, ageing nation that names a new prime minister every year. Many in China even think their economy deserves a higher score than the US, with its AAA rating.</P> <P>These views are as tantalising as they are wrong. Credit risks are rising before our eyes as China battles a worsening threat from inflation, the result of which will be slower growth. The process poses bigger risks to China's creditworthiness and the world economy than investors may realise.</P> <P>In recent years, economists and credit raters voiced a similar refrain: only when growth cools will we know the true cost of China's efforts in 2008 to ride out the global crisis.</P> <P>Somehow the official price tag, $US4 trillion, never satisfied sceptics who didn't think it possible for China to navigate the meltdown in credit markets with the ease it did.</P> <P>Give China its due: it did a masterful job shrugging off recessions among key customers. Neither Wall Street's meltdown, Europe's debt crisis or Japan's deflation knocked China off schedule in its quest to become No. 1.</P> <P>The secret to China's success? A huge, unreported accumulation of debt. Scattered around China are 20 cities that want international airports, glistening skyscrapers, five-star hotels, six-lane highways, world-class universities and cultural centres, Prada stores and ample housing. It is the largest urbanisation in modern history.</P> <P>This building boom is taking place quietly, largely beyond the control of Beijing, and financed with easy credit and local debt issuance. The surge of loans may spark a wave of bank failures that hobbles economic growth.</P> <P>The jump in local debt, which is tough to measure, increases the risk of default around the nation and leaves Beijing with a touchy question: must it bail out local governments that went too far?</P> <P>Cities and provinces can't borrow directly from banks, so they set up investment companies to skirt regulations. Fitch Ratings predicts that, because of lending to these vehicles and to real estate developers, bad loans might reach 30 per cent of the total at China's banks.</P> <P>That's not all. One of China's post-crisis revival plans calls for building 36 million low-cost homes by 2015, an initiative that would add 2 trillion yuan ($287 billion) to local government borrowing by 2012. Such plans will bump up against efforts to rein in property prices and inflation.</P> <P>Expect a huge effort to push liabilities off balance sheets, as bankers scramble to mask the extent of their lending to local governments. It's these kinds of financial shenanigans that have hedge fund managers like Jim Chanos of New York's Kynikos Associates betting against China.</P> <P>It's hard to envision a full-blown crash. China has the world's biggest currency reserves at its disposal and a command economy model that gets things done. The country also has been here before. In the late 1990s, years of state-directed credit left lenders saddled with bad loans. The government ended up spending more than $650 billion on bailouts.</P> <P>The stakes are higher now. Inflation reached 5.4 per cent in March; analysts worry that it's actually higher than that. The only answer is slower output. However, for China, with a populace appeased by the promise of prosperity, 5 per cent growth is a crisis.</P> <P>Japan's rise and fall during the past 25 years is a path China knows it must avoid. There is, of course, a difference between Tokyo and Beijing. Japan suffers from political paralysis, but China's system gives President Hu Jintao and Premier Wen Jiabao enormous latitude to steer the economy.</P> <P>Bad debt is inevitable for China. The question is, will it merely be a challenge for the national government or ruinous for the entire nation?</P> <P>No economy grows in a straight line forever. As China applies the brakes it could trigger some chain reactions around the globe.</P> <P><STRONG>Bloomberg</STRONG></P></DIV></BOD></DIV></BODY></HTML>